chap17_quest - CHAPTER 17 CAPITAL STRUCTURE LIMITS TO THE...

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CHAPTER 17 CAPITAL STRUCTURE: LIMITS TO THE USE OF DEBT Answers to Concepts Review and Critical Thinking Questions 2. The statement is incorrect. If a firm has debt, it might be advantageous to stockholders for the firm to undertake risky projects, even those with negative net present values. This incentive results from the fact that most of the risk of failure is borne by bondholders. Therefore, value is transferred from the bondholders to the shareholders by undertaking risky projects, even if the projects have negative NPVs. This incentive is even stronger when the probability and costs of bankruptcy are high. 3. The firm should issue equity in order to finance the project. The tax-loss carry-forwards make the firm’s effective tax rate zero. Therefore, the company will not benefit from the tax shield that debt provides. Moreover, since the firm already has a moderate amount of debt in its capital structure, additional debt will likely increase the probability that the firm will face financial distress or bankruptcy. As long as there are bankruptcy costs, the firm should issue equity in order to finance the project.
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